CA Lawmakers Punt Decision on Startup Tax to Governor

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California Governor Jerry Brown will now have the final say on whether small-business investors will be fully—or just partially—spared from the brunt of retroactive tax increases going back to 2008.

Unable to come down on one side of the issue or the other, California legislators chose both, approving two conflicting bills last week and leaving it to the governor to decide which one to sign. He has until October 13 to reach for his pen.

Both bills relate to a tax break that formerly allowed small-business investors in California to exclude 50 percent of their gains from the sale of qualified small-business stock when calculating their taxable income. Legislators originally designed the exemption to encourage small-business investment in the state, and it was popular among startup founders selling their companies to acquirers.

But the tax break was ruled unconstitutional last year by a California state appeals court. After the ruling, the Franchise Tax Board (FTB) said all taxpayers who had claimed the exemption since 2008 would owe back taxes, plus penalties, on the excluded income. At least 2,500 entrepreneurs would have been hit by the retroactive taxes, which the FTB estimated at $120 million to $200 million overall.

A group of legislators led by Senator Ted Lieu, a Democrat from Torrance, CA, spent much of the 2013 legislative session debating various measures to prevent the FTB’s decision from going into effect.

The Senate bill, SB 209, would reduce the exemption level from 50 percent to 38 percent. That means people who claimed the exemption in past tax years would still have to pay some back taxes—but only one-quarter as much as if the legislature had let the FTB ruling stand.

The Assembly bill, AB 1412, fully restores the 50 percent exemption for tax years between 1997 and 2016, absolving taxpayers from new financial obligations. The law would expire in 2016, and would need to be reauthorized in order for the exemption to remain in the state’s tax code after that.

The dual-bill solution emerged in the final week of the legislative session. An earlier version of SB 209 had restored the exemption to the full 50 percent level, but in August the Senate Appropriations Committee introduced an amendment that lowered the level to 38 percent, to help pay for tax refunds that may be due to taxpayers who didn’t originally qualify for the exemption.

Lieu and other opponents of the retroactive tax were unable to round up enough votes to undo that amendment. They were, however, able to slip language restoring the 50 percent exemption into an unrelated bill, AB 1412.

Both bills passed both houses of the legislature by near-unanimous votes last week. That means Governor Brown gets to make the final decision—and take the potential flak from fiscal conservatives and critics of the tax exemption. “The governor can decide whether to hold taxpayers 75 percent harmless or 100 percent harmless,” Lieu told a reporter from Bloomberg’s bureau of national affairs.

Brown has been publicly silent on the issue so far.

“We’re obviously pushing for the bill with full relief,” says Brian Overstreet, one of the founders of California Business Defense, a lobbying group formed to oppose the FTB ruling. “It’s too early to make odds, but I think the strong message from the legislature [in the form of the near-unanimous votes] bodes well.”

Wade Roush is the producer and host of the podcast Soonish and a contributing editor at Xconomy. Follow @soonishpodcast